Inventory stub period shrinkage estimates - the Tax Court sows confusion.

• Author: Wheeler, James E.
• Position: In three memoranda: Wal-Mart Stores, Kroger Co., Dayton Hudson Corp.

In the past year, the Tax Court has rendered three opinions on the use of shrinkage estimation when accounting for ending inventories using the perpetual method (Wal-Mart Stores, Inc., TC Memo 1997-1; The Kroger Co., TC Memo 1997-2; Dayton Hudson Corp., TC Memo 1997-260). At issue in each was whether shrinkage estimation produced a "dear reflection of income" under Sec. 471 and, if so, whether there were limits to the time period over which the estimate can be made.

Companies using the perpetual method of inventory accounting often take "cycle counts" of inventory on a rotation basis during the tax year and do not necessarily take a year-end inventory count. Cycle counting is cited as being more accurate; the amount of inventory counted at a given time is smaller (e.g., per department or store) and there is less time pressure than when all of the inventory is counted at year-end. In addition, cycle counting provides management with a more continuous source of information on shrinkage trends and, consequently, on the effectiveness of the company's internal inventory controls.

For a given tax year, physical inventory can exceed the book inventory records (overage) or the book inventory amount can exceed the physical count (shrinkage). Both types of discrepancy are commonly referred to as "inventory shrinkage." In the most frequent case, book inventories will be overstated and cost of goods sold will be understated when a year-end physical inventory count is not taken.

Companies that engage in cycle counting commonly estimate inventory shrinkage from the time of the last physical inventory count to year-end (stub period) for both financial and tax accounting purposes. Adjustments to year-end shrinkage estimates are made when a physical inventory count is subsequently taken in the next year. Such adjustments are usually recorded in the period in which the physical count is conducted.

Tax Accounting Rules Applicable to Inventory In Dayton Hudson Corp., 101 TC 462 (1993), the Tax Court held that Sec. 471 and the related regulations do not, as a matter of law, prohibit the use of shrinkage estimates in computing inventory at year-end for tax purposes, provided the taxpayer takes a physical inventory count at reasonable intervals." In so ruling, the court distinguished shrinkage estimates, which relate to a past event, from a reserve for loss, which relates to a future event. Left to be decided on the facts was whether the taxpayer's method of estimating inventory shrinkage was a "sound accounting system."

The Tax Court in Kroger has noted that what constitutes a sound accounting system under Regs. Sec. 1.471-2(d) has not been answered by the courts. The court interpreted the word "sound" to mean that the accounting system met the two-prong test of Sec. 471 (a). The court's focus, then, was on the taxpayer's methodology used to maintain inventories.

Does Estimating Shrinkage Meet the Best Accounting Practice Requirement? For an inventory accounting method to meet the first prong of the Sec. 471 (a) test, it must conform "as nearly as may be to the best accounting practice in the industry...." Citing Thor PowerTool Co., 439 US 522 (1979), the Tax Court in all three cases interpreted this requirement to mean that the accounting practice was widely used in the taxpayer's industry and conformed to generally accepted accounting principles (GAAP). The IRS agreed that the practice was common in the taxpayers' industries; it did not agree, however, that the practice conformed to GAAP.

The Service argued that estimating inventory shrinkage violated GAAP because such estimates were analogous to booking a reserve for self-insurance, which is prohibited by FASB Statement of...